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Fed Lifts Veil Slowly on Bank Oversight

Publication this month of findings from banks' annual stress tests will increase transparency, but many continue to call for more openness.

The Federal Reserve this month will take a step toward revealing more about its oversight of the financial system, an area where the central bank has yet to match the strides it has taken toward transparency in monetary policy.

With the scheduled publication of annual stress-test findings in March, the Fed will for the first time describe how rising interest rates could affect the health of the nation’s biggest banks.

Last year, the Fed didn’t disclose results of a similar test, even though the U.S. Treasury’s Office of Financial Research had flagged interest-rate risk as the one code-red concern in the financial system. Almost four years after the Dodd-Frank Act gave the Fed unprecedented authority over the banking industry, Democrats and Republicans alike in Congress are demanding more communication on financial risk.

“For too long, financial watchdogs were asleep on the job and American taxpayers paid the price,” said Sherrod Brown, an Ohio Democrat on the Senate Banking Committee. “There is not nearly enough transparency and accountability in their oversight of Wall Street.”

Fed officials download billions of pieces of data on loan and securities portfolios as part of their annual stress test, which measures an institution’s readiness to withstand adversity. This year the test expands to the 30 biggest banks, from 18 last year. The Fed Board of Governors has set up a special office to monitor financial stability, and a committee of supervisors, payment-systems experts, and economists to study risks across the largest banks all at once. Neither the supervisors nor the risk watchers are telling the public much about what they’ve learned.

Likewise, the Fed has said little about its new supervision of non-bank financial groups General Electric Capital Corp., Prudential Financial Inc., and American International Group Inc. Nor does the Fed have a formal way of communicating how it might use supervisory powers to head off financial bubbles. The special cross-bank group, known as the Large Institution Supervision Coordinating Committee, doesn’t publish minutes or a report.

“It is either a gaping hole, or they are very busy trying to maximize their discretion,” said Adam Posen, a former member of the Bank of England’s monetary policy committee and now president of the Peterson Institute for International Economics in Washington. Transparency boosts “market discipline, and you want that to be your corrective as much as anything else.”

Pressure to Reveal More

Representative Scott Garrett, a New Jersey Republican on the House Financial Services Committee, introduced a bill this year that would force the Fed to say more. Senator Elizabeth Warren of Massachusetts and Representative Elijah Cummings of Maryland, both Democrats, wrote to Fed Chair Janet Yellen Feb. 12 seeking more accountability and transparency on bank enforcement action.

Yellen, in a Senate hearing Feb. 27, told Warren it would be “appropriate for us to make changes” on the Fed board’s input into enforcement actions.

Warren also pressed Yellen for more disclosure about settlements on enforcement actions. “The Fed doesn’t have to wait for Congress to do that; you could voluntarily adopt that public disclosure now,” she said.

“I agree with you, it is important for us to disclose more and to disclose as much as we can,” Yellen said, adding that the Fed would “try to provide more information.”

Under Yellen’s predecessor, Ben S. Bernanke, the central bank boosted transparency in monetary policy. Bernanke began holding quarterly press conferences, the central bank described its inflation goal numerically for the first time, and officials now publish their forecasts for the policy interest rate.

Bernanke also took the step, after an intense internal debate, of publishing results of bank capital adequacy after the stress test of 2009, when the financial system was still fragile.

The Fed “has taken significant steps in the past five years to increase transparency of supervision and regulation,” spokesman Eric Kollig said in an e-mailed statement.

These include “releasing increasingly detailed, firm-specific data as part of the annual stress tests and qualitative information regarding firms’ capital planning processes; providing detailed summaries of staff and Board member meetings with outside groups regarding regulatory matters; and holding more Board meetings open to the public on regulations,” Kollig said.

Capital Levels

The Fed uses stress testing to make sure banks can manage extraordinary risks and reserve sufficient capital, instead of paying too much of it out as dividends.

The tests reveal the capital levels of banks after they are wrung through a “severely adverse scenario,” such as a deep recession. The Fed also reveals hypothetical loss rates on various categories of loans, on trading books for six banks, and—for the first time this year—counterparty risk for eight banks. All of that is a large step for a central bank that once said almost nothing about risks inside the largest banks.

Still, opacity in the process remains.

The Fed ordered JPMorgan Chase & Co. and Goldman Sachs Group Inc. to resubmit their capital plans last year, citing “weaknesses” in their processes though not in their capital adequacy. It never specified what those weaknesses were. The Fed objected to BB&T Corp.’s capital plan “based on a qualitative assessment,” even though the bank had one of the highest capital scores among the 18 banks tested.

As it turns out, JPMorgan was asked for more details on its models and portfolios, according to a person familiar with the resubmission. Goldman Sachs Chief Financial Officer Harvey Schwartz said on a conference call that it was “incorporating certain enhancements” in its stress-test process.

BB&T’s Chief Executive Officer Kelly King said he objects to the scant details provided by the Fed.

“This is something I disagree with,” King said in an interview. “We are not allowed by the Fed to talk about why we got the objection. We cannot be transparent. I would love to be transparent.”

The Fed said all of the 18 largest banks last year received “detailed assessments” of their capital planning, including feedback on areas where the plans and processes need to be strengthened.

Transparency Varies

Bloomberg News in October requested through the Freedom of Information Act the aggregate number of supervisory orders in assessment letters issued following the past four stress tests. The Fed denied the request.

Bloomberg also requested results for the rising-interest-rate scenario in the 2013 stress tests. The Fed denied the request, saying about 66 pages of information was “exempt from disclosure.” This year, the Fed will show it for the first time.

The Fed’s supervisory actions have more targeted effects than its monetary-policy initiatives do, and that helps account for the differing approaches to transparency, said Marvin Goodfriend, a former Richmond Fed policy adviser.

“The Fed is comfortable with transparency on monetary policy because it is not about individual firms or markets, but about creating macroeconomic conditions for prosperity in general,” he said.

“When the Fed is drawn into discretionary bank regulations and regulatory policy, it is often directly creating winners and losers with its decisions,” said Goodfriend, who is now a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh. “That makes central bankers uncomfortable, and may explain the apparent reluctance to be more transparent on such matters.”

Since the stress tests were introduced in 2009, the Fed has struggled over where to draw the line so it can give the public a sense of financial-system health without undermining confidence in any particular bank.

In August, the Board of Governors took the unexpected step of reporting on how the largest banks, without naming them individually, were handling the stress tests. The conclusion: All of the large banks that participated in the stress test “faced challenges across one or more” of five areas. The report may not be an annual occurrence.

Proprietary Information

“I am sensitive to the proprietary nature of individual bank issues,” said Karen Shaw Petrou, managing partner of Federal Financial Analytics in Washington, a firm that consults for large banks on financial regulation. Petrou said she “would like to see a lot more transparency” in how the Fed is devising sweeping new rules.

Garrett’s legislation would require the Fed to perform a cost-benefit analysis on new rules, as well as disclose the aggregate number of supervisory letters sent to banks, and provide an independent review of the stress tests.

The Dodd-Frank Act did contemplate a need for more accountability on Fed oversight, creating the position of vice chairman for supervision at the Fed. That job comes with a statutory obligation to testify before House and Senate committees twice a year.

The White House has never appointed anybody to the seat, though President Barack Obama’s first appointee to the Fed board, Daniel Tarullo, fills that role as the governor in charge of supervision and regulation.

Macroprudential Tools

The Fed, like many central banks around the world, is also considering a suite of so-called “macroprudential” tools that could tighten credit across entire markets without raising interest rates.

The Fed has already taken aim at one market as its low-interest-rate policy boosts prices on everything from stocks to high-risk loans. Writing regulatory guidance in March 2013 on the booming leveraged-loan market, officials spelled out what debt-to-cash-flow levels would raise concern. Usually, their guidance isn’t numerically specific.

Minutes from December’s Federal Open Market Committee (FOMC) meeting show some members grasping for ways to communicate how their concerns about financial stability mesh with their current monetary policy of keeping the benchmark lending rate near zero.

One member suggested that financial stability considerations be incorporated “into forward guidance for the federal funds rate and asset purchases.”

Yellen led Bernanke’s communications subcommittee that pushed for more monetary-policy transparency. The political and economic benefits of having a way to discuss the potential use and impact of financial stability tools and bank rules won’t be lost on her, said Michael Bordo, director of the Center for Monetary and Financial History at Rutgers University in New Brunswick, New Jersey.

“Picking winners and losers in secret, justifying things ex-post, and not laying out any criteria—that is back to the old days” when central bankers thought ambiguity was an advantage, said Bordo. “Just having to report to the Congress and the public on this function is a really good plan.”

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